EPAct 179D Experts

"The least expensive kilowatt, is the one not used."

- Jacob Goldman

The Energy Tax Aspects of Zombie Buildings

Introduction

In the current real estate market, numerous owners are being forced to
transfer their building properties back to the bank in foreclosure. In some
instances, the owner can't compete for new tenants because of inadequate cash
flow to cover needed renovations and can’t refinance the loan because the
debt exceeds the current value of the building. Other owners may have the
financial capability to make capital improvements to their property, but see
foreclosure as a better way to escape declining occupancy rates and an
overvalued mortgage. In the interim, in both of these scenarios, these often
largely vacant properties have an owner without a vested interest in ensuring
the optimal physical condition and high energy performance of the property.
Thus, the industry term “zombie building” applies.

In order to attract tenants, achieve positive cash flow, and increase
building value, the owner of a “zombie building” will necessarily
have to make substantial improvements. Energy efficient renovations that can
qualify for large immediate EPAct tax deductions will breathe new life into
these properties while improving their economic return.

The EPAct Tax Deduction

If the building project doesn't qualify for the maximum $1.80 per square
foot immediate tax deduction, there are tax deductions of up to $0.60 per
square foot for each of the three major building subsystems: lighting, HVAC
(Heating, Ventilation, and Air Conditioning) and the building envelope. The
building envelope is every item on the building’s exterior perimeter that
touches the outside world including roof, walls, insulation, doors, windows and
foundation.

Zombie Buildings Explained

Commercial real estate loans generally have a shelf life of between five and
seven years. When the market for commercial real estate was at its height, for
the majority of the last decade, investors secured commercial loans based upon
property values that have since plummeted. As those loans are becoming due,
owners are consequently defaulting on them and the result is that millions of
square footage of commercial property are unoccupied across the country. As a
result, many large commercial buildings are being foreclosed.

Because banks are not in the business of managing buildings, they either
turn to professional building management firms to manage the buildings and
prepare them for eventual future sale, or allow an outside investor to purchase
a small portion of the debt on the property in order to get a discount at the
foreclosure auction. The problem with this scenario is that the former owners
stop addressing major, important improvements when they know they are headed
for foreclosure. These owners are resistant to capital intensive projects, and
once it is apparent to them that they won’t be able to continue owning
their property, they prefer to patch up their existing building systems just
enough to get by. Complicating the matter, large buildings are complex and have
their own customized systems and unique repair and performance history. This
means that new building owners and managers normally come in blind and attempt
to review and understand the condition of the challenge they have inherited.

One of the more prominent examples of this phenomenon in action is 100
Church Street, in Manhattan, an office space with the dubious distinction, as
previously reported, of “the most unoccupied space of a completed office
building in Manhattan.” 600,000 sq. ft. of that building’s 1.13
million sq. ft. remains unoccupied. However, there has been a recent emergence
of interest in renting their office space thanks in large part to the building
owner’s commitment to making energy retrofits, so much so that it is
reported that Newsweek is close to signing a lease for 200,000 sq.
ft1.

Building Repairs & Energy Code Compliance

By making major repairs to their property, “zombie building”
owners position themselves to attract new tenants, increase the rent roll and
thereby give new life to their troubled loans.

Previously, once a building owner made the decision to repair his property,
he was permitted to renovate without having to meet current local building
codes for energy efficiency. That’s changing. For example, the recently
enacted New York City Energy Conservation Code (NYCECC) requires that any
additions, alterations, renovations or repairs done to any building must meet
current building energy code standards. Previously, if the building repairs
were done to less than 50% of a building’s major systems then the project
did not have to meet current energy code standards.

Benchmarking

Recently, five large U.S. jurisdictions, namely New York City, Washington
D.C., the State of California, Seattle and Austin have enacted building energy
use benchmarking and disclosure laws. In all of these areas the owner of a
building over 50,000 square feet (at the minimum) must disclose building energy
use to prospective tenants2. Given the growing awareness of energy
efficiency among tenants, it will become increasingly difficult to rent energy
inefficient spaces in these jurisdictions. Mandatory building-energy-use
benchmarking and disclosure gives “zombie building” owners added
incentive to make energy efficient investments because tenants will be
increasingly likely to sign new leases and thus lose the “zombie
building” distinction.

Zombie Building Tax Opportunities

Typically a “zombie building” is lagging in one or more of the
three major components of the federal EPAct legislation, namely lighting, HVAC,
and building envelope. Building owners looking to access the tax deductions
that are available through this program can combine retrofits in each of these
three building components in order to achieve the target energy reductions.

Lighting

Lighting retrofits to fluorescent, induction and LED lighting provide the
quickest economic paybacks of any energy efficient building systems upgrades.
Nationwide, over 40 utilities provide lighting rebates which in certain cases
can be worth as much as 50% of installed costs or greater. When coupled with
utility rebates and a lighting EPAct tax deduction, a lighting retrofit often
has a less than 1 year economic payback.

HVAC

HVAC is the largest building energy user in office buildings. During the
economic downturn many office buildings deferred large system HVAC projects
that now must be addressed. One basic HVAC technology that typically generates
EPAct tax incentives is chillers, typically in buildings less than 150,000
square feet. For larger buildings, the owner should consider installing a
hybrid chiller, which can alternate between two fuel sources, typically natural
gas and electricity, based on the fuel source that is less expensive at the
present time. Office “zombie building” owners that want to leapfrog
in front of the competition should consider also installing thermal storage
systems. Unlike traditional cooling systems, thermal storage systems make ice
at night during off-peak hours, when rates for electricity are typically much
lower, and then pump the cold water that is produced throughout the walls in
order to cool the offices during the day. The EPAct tax provisions actively
encourage property owners to use less power by utilizing this or similar
technology, which function to overcome the electricity price differential by
capitalizing on the so-called “time of day” pricing difference. As
set forth under the Electricity Section of the Energy Policy Act of 2005, each
electric utility must offer all of its customers a time-based rate schedule. In
addition, because thermal storage systems save so much daytime electricity use,
state and local utility programs will often provide large rebates.

The following chart illustrates the potential EPAct tax benefits for a few
publicly disclosed previously challenged buildings:

Additional Tax Opportunities Pertaining to Zombie Buildings

Pursuant to Internal Revenue Code Section 48, a tax credit or cash grant is
available for the installation of qualifying energy efficient specific
equipment. These credits and/or grants mainly apply to the installation of
technologies including alternative energy properties, like solar P.V. or
geothermal heat pumps, and therefore may only be attractive to owners in
certain climate regions with appropriate environments3. Cash grants
are particularly appealing to “zombie building” owners, since tax
credits generally are of limited value to building owners that are losing money
on their property. This option is exclusively made available for projects that
have “begun construction” during 2009 or 2010. The U.S. Department
of Treasury has recently issued guidelines in order to clarify the meaning of
construction that has “begun.”4 In order to access these
tax credits or cash grants careful tax planning needs to be considered.

How to Finance Energy Retrofits

The all-important question that needs to be addressed when it comes to
retrofitting “zombie buildings” is how these buildings’
owners can raise the money necessary to invest in energy-efficient
improvements. Major vendors of energy equipment around the country are keen on
the growing demand for this lending market. Many of them offer their own
financing programs, whereby building owners interested in retrofitting their
property qualify for an energy savings based loan. Encouragingly, several major
banks and brokerage firms are in the process of establishing financial
instruments specifically designed to free up cash for owners of commercial
property around the country.

Conclusion

The usual goal of a “zombie building” owner is to quickly make
the building as desirable to potential tenants or buyers as possible. Making
energy efficient building upgrades will not only help the building become more
valuable, but can provide up-front investment relief in the form of EPAct tax
deductions, tax credits or cash grants, and utility rebates, and will improve
the building’s overall publicly disclosed energy benchmarking numbers.
Increasingly, more and more outside financing aid is being made available by
energy equipment vendors and lending institutions, which can further reduce the
initial investment burden on the building owner. The owner of a “zombie
building” may feel at times like they are in quick-sand, falling deeper
and deeper into the hole with no way out in sight. However, financial recovery
and property viability is a realistic expectation for those owners who are
willing to engage in the EPAct tax-incentivized improvements that are described
above.